ETF Series, Part 1: What Are ETFs?

Understand the major differences between stocks, mutual funds and ETFs in part one of Schwab's series on ETFs.

Some people tend to think of ETFs like single stocks, while others believe they are more akin to mutual funds. There’s no question that ETFs share characteristics with both, but understanding the differences is especially important for active traders.

When you invest in an ETF, you are buying into a pooled investment vehicle (similar to a mutual fund), but unlike mutual funds (which allow investors to buy or sell one time each day), ETFs are traded throughout the day on organized stock exchanges (just like common stocks). Most ETFs are passive, which means that they use a published index to determine which securities to hold and how to weight those securities in their portfolios. However, some ETFs are actively managed, and their investment decisions are made by a portfolio manager. Almost every investment niche – from small-cap stocks to emerging market or oil – can be filled by an ETF.

Different sources of liquidity

ETFs, mutual funds and single stocks have different sources of liquidity. When investors purchase or sell shares of mutual funds, they do so directly from fund sponsors at a price calculated at the end of each trading day. This price is called the net asset value or “NAV”, and the process of transacting directly with a fund sponsor is known as “primary market liquidity”.

ETFs also offer primary market liquidity, but only for very large transactions conducted by authorized participants (or APs). Other investors purchase and sell shares between each other and large ETF dealers (or “market makers”) on national stock exchanges (or the “secondary market”). This means that like stocks, ETFs can be bought or sold with standard, equity order types (e.g. market and limit orders), and investors can specify how long an order should be in-force (e.g. day-only, good-until-canceled, fill-or-kill, etc.). ETFs may also be purchased on margin or sold-short, and options (e.g. puts and calls) are also available on many ETFs.

Different transaction and holding costs

Both mutual funds and ETFs earn money for their sponsors via operating expense ratios (or OERs – there is no OER on individual stocks). The OER is an annual rate that the fund charges on the total assets it holds. This fee covers portfolio management, administration and other costs. Selecting ETFs with low OERs is especially important for long-term, buy-and-hold investors since the expense ratio is an ongoing fee. Short-term traders may be more interested in the other costs associated with ETFs – commissions, bid/ask spreads and premiums/discounts to NAV.

On Schwab.com, you can look up any ETF using the Quote Detail page. Scrolling down on the page, you will see the Gross Expense and Net Expense ratios. The Net Expense Ratio is the most useful figure for understanding the current expenses that fund investors are paying. (You should also consider the impact that the gross expense ratio may have on future performance if certain arrangements limiting fees expire or are no longer available.) The figure below shows the exact location of this information.

FOR ILLUSTRATIVE PURPOSES ONLY

In general, brokerage firms charge an online commission that can range from $4.95 to $19.95 for trades made without the assistance of a broker, in much the same way they charge to execute stock trades. This fee level can vary even more depending on brokerage firm, account type, trading frequency, and whether the transaction is made online, in person or over the phone. Many brokerage firms are now waiving commissions on certain ETF trades. For example, ETFs in the Schwab ETF OneSource™ program are available to trade commission-free, online in a Schwab account.1

Bid/ask spreads are another important cost consideration for active traders (and represent another way in which ETFs are similar to individual stocks). The "ask" (or "offer") is the market price at which an ETF can be bought, and the "bid" is the market price at which the same ETF can be sold. The difference between these two prices is commonly known as the bid/ask spread. You can think of it as a transaction cost similar to commissions except that the spread is built into the market price and is paid on each roundtrip purchase and sale. So, the larger the spread and the more frequently you trade, the more relevant this cost becomes.

Finally, active traders should pay attention to premiums and discounts to NAV. An ETF is said to be trading at a premium when its market price is higher than its NAV. And an ETF is said to be trading at a discount when its market price is lower than its NAV. In general, most ETFs exhibit small discounts and premiums, and when material differences do arise, APs usually help the market self-correct by attempting to profit from arbitrage trades (possibly via accessing the primary market) to bring an ETF's market price and NAV back into better alignment.

Important Disclosures

1Conditions Apply: Trades in ETFs available through Schwab ETF OneSource™ (including Schwab ETFs™) are available without commissions when placed online in a Schwab account. Service charges apply for trade orders placed through a broker ($25) or by automated phone ($5). An exchange processing fee applies to sell transactions. Certain types of Schwab ETF OneSource transactions are not eligible for the commission waiver, such as short sells and buys to cover (not including Schwab ETFs). Schwab reserves the right to change the ETFs we make available without commissions. All ETFs are subject to management fees and expenses. Please see the pricing guide for additional information.

Investors should consider carefully information contained in the prospectus, or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Past performance cannot guarantee future results.

Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Individual securities mentioned are for illustrative purposes only and not a recommendation to transact in any security.

Short selling is an advanced trading strategy involving potentially unlimited risks, and must be done in a margin account. Margin trading increases your level of market risk. For more information please refer to your account agreement and the Margin Risk Disclosure Statement.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Please read the Options Disclosure Document titled Characteristics and Risks of Standardized Options. Supporting documentation for any claims or statistical information is available upon request.

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